The man who led Portugal as it took a 78 billion euro bailout from the Eurozone and International Monetary Fund will face his third day of questioning Monday in connection with a police investigation into corruption.

Jose Socrates, a Socialist who was prime minister from 2005 to 2011, was arrested late Friday and detained all through the weekend as part of an inquiry into suspected tax fraud, corruption and money-laundering, Reuters reported Socrates’ lawyer Joao Araujo as saying.

Araujo declined to say whether Socrates had been charged with any crime or admitted to any wrongdoing. The maximum penalty for corruption in Portugal is eight years in prison.

It’s the first time since Portugal emerged from fascist dictatorship in the 1970s that a former premier has been detained. Socrates’ arrest follows the arrests of other high-ranking officials or prominent people in separate inquiries in the past few months as prosecutors intensify a fight against corruption in a country notorious for its slow justice system.

It was not clear if the inquiry, known as “Operation Marquis”, was linked to Socrates’ time as premier in 2005-2011.

During his premiership, Socrates weathered several investigations, including allegations that he misused his post as environment minister in 2002 to allow the construction of a shopping mall. He denied wrongdoing and faced no formal charges.

Prosecutors are investigating several prominent people in separate corruption and fraud cases, including the head of the country’s immigration service, who was arrested last week on suspicions of corruption linked to the issuing of so-called “golden visas” to wealthy foreign investors.

Socrates resigned as prime minister in the middle of his second four-year term after requesting the bailout, which forced widespread and deeply unpopular cuts in public spending and increases in taxation.

The country exited the bailout program in May, but was accused by the IMF two weeks ago of backsliding on necessary reforms.

The IMF said next year’s budget deficit is likely to be far higher than the government admits, at 3.4% of gross domestic product, and is “not in line with the commitments in the present medium-term fiscal framework.” It also warned that a huge corporate debt hangover was threatening to derail the economic recovery.

That legacy of excess corporate debt was evident earlier this year in the collapse of Portugal’s, Banco Espirito Santo SA, whose loan losses in the recession finally caught up with it in the summer after years of evasive accounting.

Why Germany is the Eurozone’s biggest free rider

As worries rise that the eurozone is slipping into recession, it’s clear Germany is doing way better than its neighbors. Today, the country has low unemployment, very low inflation, a large trade surplus and a balanced budget. By contrast, most members of the Eurozone are stagnating, while some are going through a catastrophic recession and suffering from debilitating unemployment. The German government says that its own success and its neighbors’ failures are unrelated; that poor performance is due to poor decisions. Yet, even though the policy failures are real enough, this analysis is false.

Germany has for many years pursued a policy of wage suppression, which many economists have described as a competitive devaluation or ‘beggar thy neighbor’ policy. Germany’s gains in competitiveness were immediately translated to gains in trade, since the freedom of goods, services, persons and capital allowed German products to circulate freely and quickly throughout the European Union. These are the fundamental freedoms of EU law and are vigorously protected by the European Court of Justice. German policy would not have been successful without them

Germany has also benefited from the fixed exchange rate that the Euro effectively secures between itself and its major European markets. This means that its export boom was not offset by a rise in its own currency. If Germany had been outside the Euro, currency appreciation would have hurt Germany’s gains. Not so in the Eurozone.

While Germany has benefited so much from the Eurozone, its less successful partners are left to fend for themselves. The Eurozone lacks the automatic stabilizers that other currency unions apply among the various regions — namely, fiscal transfers such as unemployment and housing benefits, shared health care costs, or the pooling of bank risks and deposit insurance. The Eurozone also lacks the large movement of workers across state borders enjoyed by the United States, mostly due to language and regulatory barriers. These institutional features of the Eurozone have created a highly unfair economic union, which magnifies disproportionately the consequences of failure.

Germany might respond, ‘Tough, the others ought to have seen it coming.” All members of the Eurozone are subject to the same competitive environment. All consented to its design by ratifying the relevant treaties. All had a chance to adjust. Yet this argument is false too.

Not everyone had the same chance to adjust. As I argue in my recent article for Foreign Affairs (‘Misrule of the Few: How the Oligarchs Ruined Greece’, ) membership in the European Union has not improved the institutions of the weaker members. It has actually made them worse.

When they joined the EU, Greece, Ireland, Portugal and Spain opened their borders and exposed themselves to new waves of trade, immigration and finance. Competition with other member states was meant to bring about ‘creative destruction,’ whereby inefficient firms – i.e. those who could not compete internationally – would go out of business. In order to avoid short-term hardships, the peripheral economies were set to receive large sums of EU funds by way of compensation. These funds were supposed to be invested in restructuring the domestic economies. But this happened very imperfectly.

The funds strengthened those who administered them. In the absence of a strong civil service in most of the peripheral EU members, these were simply the local political classes. In small societies with weak checks and balances, the effect was transformative. This money operated as a ‘natural resources curse’. Since the money was not the result of taxation, domestic accountability for its spending was seen to be an unnecessary luxury.

This situation was made worse once the Eurozone was created. With the ECB looking away, Spain, Portugal, Ireland and Greece built not only asset bubbles with cheap and easy credit (which happened elsewhere) but also opaque and politically driven banking systems. As a result, cheap credit impeded reform and damaged institutions in all the countries of the periphery.

Membership in the Eurozone directed funds to wasteful investment, made cronyism exceptionally profitable, provided new incentives for political corruption and strengthened already existing hierarchies. If all the members of the Eurozone were equally strong, if they all had, for example, an outstanding and independent banking regulator, a powerful judiciary and strong internal mechanisms of accountability, perhaps these things would not have happened. Yet, they did happen.

The examples of the failed banks, Bankia in Spain, Allied Irish in Ireland, and Proton in Greece speak for themselves. In Greece, in particular, the EU has stood by while the political system has been undermined by a small group of oligarchs who have illegally occupied television frequencies for 25 years. By escaping any effective regulation and controlling news and commentary for their own purposes, they have dominated political and business life and undermined the credibility of the political class in its entirety. The bailout deal with the ECB, the International Monetary Fund and the European Commission has not touched their privileges.

In some of the members of the Eurozone the main legacy of the Euro is economic implosion, rising inequality and widespread corruption. This is not the result of isolated domestic failures. It is a result of collective European decision-making that misfired spectacularly throughout the periphery. The relentless pursuit of an ‘ever closer union’ made EU institutions neglect the question of the quality of this union. It is time to change course. Unless Europe addresses the deep unfairness at the heart of the Eurozone, the crisis is not going to end.

Pavlos Eleftheriadis is Associate Professor of Law and a Fellow of Mansfield College at Oxford University.

Portuguese government steps in to save Banco Espírito Santo

The Portuguese government has stepped in with a $6.6 billion plan to rescue beleaguered lender Banco Espírito Santo, officials said Monday.

The bailout is a first test of European rules that were re-designed so that investors, and not just taxpayers, cover the cost of failing banks. The Portuguese government will provide most of the rescue funds in the form of a loan, but the majority of the losses will be taken on by Banco Espírito Santo shareholders and some creditors.

The bailout plan will transfer Banco Espírito Santo’s healthy businesses, including deposits and loans likely to be repaid, to a new bank called Novo Banco, while the remaining problem assets will remain with Banco Espírito Santo and be shut down over time.

Shareholders in the old bank and creditors who took on more risk, including French bank Crédit Agricole and the Espírito Santo Financial Group, may lose all their investment. Other creditors had contracts that offered more protections and should recover some of their money.

Portugal’s government will provide $5.9 billion of the $6.6 billion cost of the bailout, even though the Bank of Portugal tried to pass off the deal as being paid for by the country’s bank resolution fund, an account funded by financial institutions.

The government eventually plans to sell off the newly-formed Novo Banco in order to recover the taxpayer loan.

The European Commission approved the plan, which is a setback for the country after it exited a $105 billion three-year bailout loan from the European Union and International Monetary Fund in May.

From the eurozone’s periphery, some good news at last

It seems like years since good news came out of the countries scattered around the fringe of the eurozone, but the signs are increasing that things are finally starting to improve.

Leading the way right now is Spain, where the latest figures put the existence of a recovery beyond reasonable doubt. In its latest quarterly survey out Thursday, the National Statistics Institute, INE , said that the economy had created 192,000 jobs in the last year, while unemployment was now down 7% from its peak.

The INE said that joblessness had fallen in all major sectors, including construction and manufacturing, which were both devastated by the implosion of a housing bubble in 2008 that crippled the country’s financial system, forcing it to take a €41 billion ($60 billion) bail-out from the eurozone and International Monetary Fund to shore up its banks.

Unemployment remains painfully high–at 24.5%, Spain still has one of the highest jobless rates in the world. But unlike much of Europe, it’s now growing fast enough to create jobs. The INE’s survey comes only a day after the Spanish Central Bank said growth accelerated in the second quarter to 0.5% from 0.4% in the first. It also raised its forecasts for growth next year to 2%, from a previous forecast of 1.7%

Like Ireland and Portugal, Spain has now exited its bail-out program, and all three governments have been confident enough to do that without arranging precautionary credit lines (which would have been tied to still more politically unpopular conditions by their lenders).

But arguably the more eye-catching development in the last few days has been in Portugal. On Tuesday, the country’s second-largest bank, BCP Millennium SA. said it had managed to raise €2.25 billion in new equity, allowing it to repay state bail-out money, despite a blast of negative publicity from its largest rival, Banco Espirito Santo SA.

Two years ago, before European Central Bank President Mario Draghi promised to do “whatever it takes” to save the euro, none of Portugal’s banks was able to sell debt, let alone equity, on public markets. The notion that one could have done so even while its neighbor was imploding would have been absurd.

The lesson of the last weeks in Portugal appears to be that markets have learned to separate the wheat from the chaff. There are no more panicked, generalised sell-offs (except only very brief ones), and the problems of individual institutions no longer read across automatically to their rivals, or to the rest of their economy, and still less to the economies of other countries perceived to be “in the same boat.” ‘Contagion’, to use the economists’ buzz-word, has been contained.

BES’s problem borrower has now filed for protection from its creditors, but BES’s shares are up over 25% from their low-point last week. Big money investors such as Goldman Sachs have placed sizeable bets on it recovering further. Meanwhile, Portugal’s 10-year bond yields have fallen 0.30 percentage point to 3.70%.

“The countries that once had to ask for external help have done their homework and are among the best performers in Europe,” says Holger Schmieding, chief economist at Berenberg Bank in London.

The problem now, he says is firmly with those countries that haven’t been forced to reform by the threat of national bankruptcy–Italy and France.

Europe markets tumble as Portuguese bank woes rattle nerves

Remember the euro crisis? If not, take a look at the markets today to remind yourself.

European markets have taken a hard fall out of bed Thursday, on fears for the strength of Portugal’s largest listed bank, Banco Espirito Santo SA, whose shares were suspended in Lisbon after falling 17%.

The Euro Stoxx 600 index is down 1.0%, the main Lisbon index is down 4.2%, and the bond yields of governments on the stressed periphery of the euro zone have shot up, while yields on bonds perceived as safe, like Germany’s, have fallen as investors flee to quality. Gold prices, another barometer of fear, are up 1.1% at a three-month high of $1,338.80 an ounce.

As so often with the eurozone, it’s not so much the proximate cause of the turmoil that’s worrying: it’s what that cause says about the eurozone’s broader failings: its lack of a common treasury to back its currency, its slowness in cleaning up its banks, and the risk that its weakest members will never be able to repay their debts.

Nor does it help that both France and Italy both announced shock falls in manufacturing output in May earlier Thursday, further denting confidence in the eurozone’s ability to grow its way out of its problems.

B.E.S.’s woes have been leaking out gradually for months. Like many European banks, it has created ever more arcane shareholding and voting structures over the years to ensure that the descendants of its founder keep control, despite the fact that they now only hold 25%, and even that only indirectly.

That structure (pictured below), which was propped up by forcing an affiliated fund manager to make massive indirect loans to B.E.S. during the crisis, is now unraveling, although it still isn’t clear where exactly the problem assets are (it’s possible they might not actually be on the bank’s balance sheet).

Understand this? Portugal’s banking regulator thought it did…

But so much for the problems of a dying banking dynasty. What’s more important is that the Portuguese government’s borrowing costs have shot up by 0.36% in the last two days to 3.98% today, a three-month high.

As Raoul Ruparel, an analyst with the Open Europe think-tank, points out, “the sovereign-bank loop has not been fully broken, and fears clearly remain regarding bailouts and backstops.”

In other words, the old problem–that many of Europe’s banks are bust, their governments are too weak to save them–still hasn’t been solved.

The eurozone in principle agreed mechanisms that were supposed to solve this last year: the E.U. agreed a grandly-titled Bank Recovery and Resolution Directive to ensure shareholders and bondholders pay first for future bank failures; it put the E.C.B. in charge of supervising 130 of the eurozone’s largest banks, and created a Single Resolution Mechanism to stop those banks hiding their problems behind cozy arrangements with national supervisors and governments.

But B.E.S. has fallen into a huge crack between the political agreements and the date when the new rules will kick in. The B.R.R.D. and S.R.M. only enter into force in 2016. The E.C.B., meanwhile, takes over as supervisor in November this year, and it appears to have been the Portuguese central bank’s preparations for that–going through the books and exposures of its largest institutions–that started this snowball rolling six months ago.

For markets, that begs the question of what skeletons might be shaken out of other eurozone cupboards as the E.C.B. prepares to take over. And it explains why it isn’t only Portugal’s bond yields that are rising today. Italy’s 10-year yield is up 0.12 percent, Spain’s is up 0.07 percent, Greece’s is up 0.22 percent.

Only a couple of months ago, Portugal exited its €78 billion bail-out without even requesting a precautionary credit line as a safety net. Markets, meanwhile, were snapping up new bond and stock offerings from eurozone banks, sedated by promises of endless cheap money from the E.C.B.. They even started to lend to Greece again.

But Thursday’s news showed how quickly fear can still run through the system in the absence of proper backstops: Banco Popular Espanol SA, one of Spain’s largest banks, canceled the sale of a contingent convertible bond, while Greece itself cut the size of a planned three-year bond to only €1.5 billion, half of what it had hoped.

Christian Schulz, an economist with German investment bank Berenberg in London, said however there’s no reason to think that the crisis is coming back in a meaningful way.

“The one thing I would worry about is a bank run, but they have the tools to stop even that,” Schulz said. He said that correlation–banker-speak for people dumping and/or buying everything at once in response to the same piece of news–“is unavoidable for a short period of time.”

Why a problematic Portugal matters

All eyes are on Italy this week, but they shouldn’t overlook Portugal, which has also caught the Greek flu — and it’s serious. Moody’s downgraded the tiny European nation’s sovereign debt to junk status last week on fears that it would need a second bailout from Europe to pay off its creditors. The move shocked analysts and traders who were just recovering from a major panic attack over a potential default situation in Greece.

While some have dismissed Portugal as irrelevant, this downgrade should not be taken lightly. Although it’s true that Portugal’s economy is small, even smaller than that of Greece, its public debt — and more importantly its private debt — sit on the books of nearly every major European banking institution. At the same time, much of its debt is secured by credit insurance instruments issued by several U.S. banks, exposing them to losses too. For now, the European Central Bank says it will continue to support Portugal by repurchasing its debt, but this latest downgrade has made it much tougher for the country to try and dig itself out of its debt hole.

For starters, it should be said right off the bat that few expect Portugal to default on its debt anytime soon. Unlike with Greece, where a default last month seemed imminent, Portugal is seen to be in a potential default situation sometime in 2013. That’s because it just received a big bailout loan from the European Union and the International Monetary Fund to help service its debts. Under the terms of the deal hammered out in May, Portugal will receive 78 billion euros over time, which, like Greece and its 110 billion euro loan approved last year, is contingent on the country’s ability to meet certain debt reduction targets.

Greece’s main problem is that it has failed to make any meaningful progress in reducing its debt and getting its economy back on track. Portugal, on the other hand, has made great strides in getting its house in order. The terms of its loan specify that the country should cut public spending by 7% while holding revenues flat. Portugal is doing pretty good so far as revenues are up 9% from last year while government expenditures are down 4%. Its central government debt is now 69% smaller than where it was last year. UBS projects that Portugal should therefore “comfortably” achieve its 5.9% deficit target agreed to with the IMF as part of its loan.

Compare that to Greece, where revenues are down 5% while central government debt is up 13% from where it was last year and you begin to see why the markets have been more concerned with a default out of Athens as opposed to one from Lisbon.

Portugal’s relative success in combating its debt troubles is why the market was thrown off guard by the downgrade this week. Everything seems to be on track for the country and it just received its first installment of its loan from the IMF at the end of June. A new conservative government is expected to push through a large austerity package in the coming months while it ramps up assets sales to help meet the future debt targets.

What happens in Greece…

But Moody’s is still concerned that Portugal will end up like Greece when all is said and done. The ratings agency does not have faith in the new Portuguese government’s ability to cut spending fast enough to service its debt. It’s also concerned about talk that Europe may force private investors in Greek sovereign debt to take a haircut on their investment. Analysts believe that talk of such an action would ultimately discourage further private investment in Portuguese debt, therefore making the country dependent on the European Central Bank to buy any new debt it needs to issue in the future.

It’s unclear if the Portuguese will be successful in slashing their way to fiscal normality. In Greece, the passage of harsh austerity measures last year caused its GDP to shrink as it was forced to lay off thousands of people from its bloated public sector. Portugal will face similar troubles as it starts to make cuts. And thanks to Moody’s downgrade, it will now have to pay more to issue new debt. Many investment firms are not allowed to invest in junk bonds, therefore forcing Portugal to raise yields to attract speculative investors.

At first glance it seems like the market is overreacting to Portugal’s debt woes. But take a closer look into the country’s financials, and it’s clear why Moody’s is concerned. The nation’s debt to GDP ratio stands at around 93%, which is far less than Greece at 140%. But Portugal’s problem is its private debt load, which is a whopping 230% to GDP, thanks in large part to its citizenry borrowing billions of euros to pay for their new upgraded lifestyle.

Credit Suisse estimates that a third of the cost of getting rid of the excess private debt will eventually be imposed on the government, pushing the nation’s debt to GDP ratio up to 134% by 2014. To pay off that debt, the government will need to issue even more debt, which is now much harder to do. That would be fine if the country’s economy was growing, but it grew by just 0.5% per year over the last decade and is now expected to slow once the new government initiates all those austerity measures.

Portugal will be watching what happens in Greece very closely. If the Europeans force private investors to take a haircut on their debt, Portugal will surely want the same. Credit Suisse estimates that Portugal will probably need a 30% cut on its government debts, which is larger than most, thanks to all that private debt due to fall on its books. This is like moral hazard on a monumental scale as Ireland, Spain and possibly even Italy would likely request a haircut on their debt. The cumulative effect could crush Europe’s banking sector.

Foreign bank holdings

So how bad could it be? As of the third quarter of 2010, Portugal had around $321.8 billion worth of private and public debt held by foreign institutions, more than Greece, which had $277.9 billion, according to the Bank of International Settlements. The bulk of Portugal’s exposure is from eurozone investors to the tune of $232.6 billion. Therefore a 30% haircut on Portugal’s total debt would amount to a hit to European investors to the tune of around $70 billion.

A large chunk of that debt is held by banks and investors in France and Germany, which had direct exposures to Portuguese debt at the end of 2010 of around $27 billion and $36 billion, respectively. But that’s not all the exposure they have. Banks in those countries sold other investors insurance on Portuguese debt through credit default swaps, which would pay out if the country ever defaulted on their debt. Adding in the CDS, the net exposure to Portuguese debt jumps to $32.3 billion for France and $50.2 billion for Germany.

The swaps play a key role in U.S. exposure. It has just $5.2 billion in direct exposure to Portuguese debt, but when you add in the CDS, the total net U.S. exposure pops to $46.5 billion, putting it roughly on par with total German exposure.

These are quite large numbers coming from such a small country. But those numbers pale in comparison to a possible Irish default. Ireland has more foreign debt outstanding than both Greece and Portugal, combined, with a mind-blowing $813.7 billion. That means that foreign investors could be facing losses of around $424 billion if all three countries have their collective private and public debt loads slashed by 30%.

That’s nearly half a trillion dollars, and we haven’t even started to talk about Spain or Italy yet. Their foreign debt loads are multiples of Portugal, Greece and Ireland as they both have very active debt markets.

So while Portugal is a small country with just 11 million people, this downgrade has set in motion a series of events that have European leaders understandably on edge. Some have called for credit ratings to be totally suspended on nations receiving bailout funds while they get their house in order. But a lack of a credit rating won’t make them more attractive to investors. Eventually, someone has to take a hit on all this bad debt floating around Europe and investors are scrambling to get as far away from the explosion as possible.